6 June 2017 External T.I. 2016-0658351E5 - Stock dividends and safe income

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: How does the safe income of a corporation contribute to gains on the stock dividend shares and the shares upon which the stock dividend is paid?

Position: For shareholders who are individuals, a corporation’s safe income contributes to the stock dividend shares and the shares upon which the stock dividend is paid based on the relative gains inherent in the shares, as determined immediately after the stock dividend is paid. For corporations, the rules in subsection 55(2.3) and paragraph 52(3)(a) are relevant.

XXXXXXXXXX								2016-065835
									Nicki Verlinden
(416) 973-2228
June 6, 2017

Dear XXXXXXXXXX,

Re: Subsection 55(2) and stock dividends

This letter is in response to your e-mail dated July 19, 2016 in which you requested our views regarding the extent to which safe income contributes to a gain on shares issued on the payment of a stock dividend (the “stock dividend shares”) and on the shares upon which the stock dividend is paid. Unless otherwise stated, all statutory references herein are to the Income Tax Act (Canada) (“Act”).

In your email, you stated that subsection 55(2.3), which is applicable to dividends received after April 20, 2015, streams the safe income to the stock dividend shares, rather than the shares upon which the stock dividend is paid, where the dividend recipient is a corporation. Furthermore, you stated that it is your understanding that before the addition of subsection 55(2.3), the safe income was streamed proportionately between the stock dividend shares received and the shares upon which the stock dividends were paid based on their relative gains.

Your specific question is: how does the safe income of a corporation contribute to gains on the stock dividend shares and the shares upon which the stock dividend is paid in light of subsection 55(2.3) and amended paragraph 52(3)(a)?

OUR COMMENTS

This technical interpretation provides general comments about the provisions of the Act and related legislation. It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R7, Advance Income Tax Rulings and Technical Interpretations.

We have prepared the following hypothetical scenario to illustrate your query:

Opco has two shareholders that each own 50 of its issued and outstanding 100 common shares, which are voting and participating. The shareholders are Holdco, a corporation resident in Canada; and Ms. X, an individual resident in Canada. Each of Holdco’s and Ms. X’s 50 common shares of Opco have an adjusted cost base (“ACB”) of $5,000 because they were acquired at the same time. Opco has a fair market value (“FMV”) of $1,000,000.

The income earned or realized by Opco after 1971 and before the safe-income determination time for the transaction, event or series, as defined in paragraph 55(5)(c) (“safe income”) that contributes to Holdco’s and Ms. X’s inherent capital gain on their respective 50 common shares of Opco is $450,000 each (i.e., $900,000 in total).

Opco paid a stock dividend of $700,000 on its common shares in the form of 1,000 preferred shares with a redemption amount and FMV of $700 per share. Opco increased its paid-up capital (“PUC”) by $1 when it paid this stock dividend. Consequently, each of Holdco and Ms. X received 500 preferred shares as a stock dividend on their 50 common shares of Opco.

This example assumes that both shareholders own the same classes of shares, with the same rights, privileges, conditions and restrictions. This example also assumes that one or more of the purpose tests in subsection 55(2.1) have been met.

Subsections 55(2.2) to 55(2.4) apply in respect of stock dividends received by “dividend recipients”. A “dividend recipient” is defined in subsection 55(2.1) to be a corporation resident in Canada; therefore these rules do not apply to Ms. X.

For the purposes of subsections 55(2), (2.1), (2.3) and (2.4), subsection 55(2.2) deems the “amount” of the stock dividend received by Holdco and Holdco’s entitlement to a subsection 112(1) deduction, to be $350,000. This is the greater of (i) the FMV of the 500 preferred shares issued as a stock dividend at the time of payment, and (ii) the PUC increase to Opco by reason of the payment of the stock dividend.

Subsection 55(2.4) states the three conditions that must be met in order for subsection 55(2.3) to apply in respect of the stock dividend. In the above scenario, these conditions are met vis-à-vis Holdco.

Subsection 55(2.3) states the following in respect of a stock dividend:

(a) the amount of the stock dividend is deemed for the purpose of subsection (2) to be a separate taxable dividend to the extent of the portion of the amount that does not exceed the amount of the [safe income] that could reasonably be considered to contribute to the capital gain that could be realized on a disposition at fair market value, immediately before the dividend, of the share on which the dividend is received; and

(b) the amount of the separate taxable dividend referred to in paragraph (a) is deemed to reduce the amount of the [safe income] that could reasonably be considered to contribute to the capital gain that could be realized on a disposition at fair market value, immediately before the dividend, of the share on which the dividend is received.

With respect to Holdco’s 50 common shares of Opco, the capital gain that could be realized on a FMV disposition thereof immediately before the stock dividend is received is equal to $495,000 (i.e., FMV of $500,000 minus ACB of $5,000). The “amount” of the dividend is $350,000 as stated above, and this amount does not exceed the amount of the safe income that could reasonably be considered to contribute to the capital gain that could be realized on the 50 common shares (i.e., $450,000 as stated above).

Therefore, the amount of the stock dividend received by Holdco deemed to be a separate dividend for the purpose of applying subsection 55(2) is $350,000, and this amount is deemed to reduce Opco’s safe income that contributes to the gain on the 50 common shares, pursuant to paragraph 55(2.3)(b). Immediately after the stock dividend is paid, Holdco will own (i) 500 preferred shares with a FMV and an ACB of $350,000, pursuant to paragraph 52(3)(a) and (ii) 50 common shares with a FMV of $150,000 and an ACB of $5,000, resulting in an inherent capital gain of $145,000. At that time, Opco has $100,000 of safe income that contributes to the inherent capital gain on Holdco’s original 50 common shares. The other $350,000 of safe income is now reflected in the ACB of the 500 preferred shares received by Holdco as a stock dividend, pursuant to paragraph 52(3)(a).

With respect to Ms. X, immediately after the stock dividend is paid, she will own (i) 500 preferred shares of Opco with a FMV of $350,000 and an ACB of $0.50 (footnote 1), resulting in an inherent gain of $349,999.50 and (ii) 50 common shares of Opco with a FMV of $150,000 and an ACB of $5,000, resulting in an inherent gain of $145,000. Opco’s safe income that contributes to the gain on the 50 common shares held by Ms. X is not reduced by the stock dividend paid to Ms. X (i.e., Opco’s safe income that contributes to Ms. X’s shares after the payment of the stock dividend is still $450,000). This safe income of $450,000 will be apportioned between Ms. X’s 500 preferred shares issued as a stock dividend and her original 50 common shares based on their respective gains, as determined after the payment of the stock dividend. In this example, the safe income that reasonably contributes to the $350,000 inherent capital gain on Ms. X’s 500 preferred shares is therefore $318,182; (footnote 2) and the safe income that reasonably contributes to the $145,000 inherent capital gain on Ms. X’s original 50 common shares is $131,818. (footnote 3)

We trust the above comments to be of assistance.

Yours truly,

Yves Moreno
for Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 Subparagraph 52(3)(a)(i) and definition of “amount” in 248(1)(c)

2 Total gains = $350,000 + $145,000 = $495,000. Gain on preferred shares = $350,000/$495,000= 70.7% X $450,000 safe income = $318,182 safe income contributing to preferred shares.

3 Gain on common shares = $145,000/$495,000= 29.3% X $450,000 safe income = $131,818 safe income contributing to common shares.